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Why the government needs to give services room to grow

    It is close to a certainty that the Chancellor George Osborne will talk about a budget for growth tomorrow to help maintain the momentum of the country’s economic recovery. We pointed out recently that despite the overall fragility of the economic recovery in the UK, measured in terms of GDP growth, the revival in the services sector has been relatively more robust than in manufacturing or construction. Unfortunately, government services constitute a significant part of this sector and evidence from the ONS suggests that productivity in the sector has been stagnant in real terms since 1997 absorbing resources, but producing no additional quality adjusted output. This is consistent with the findings of a recent CPS research paper by the author which estimates that the relationship between public expenditure on health, education and welfare for a large sample of OECD countries was negative.

    Are You Being Served?

    It was suggested in a recent CPS Growth Bulletin that “the relative strength in the volume of services output growth under this Government compared to under Labour must be partly due to the necessary rebalancing of the economy between the public and private sectors that has happened since the election.” This report looks more closely at the services sector and its components in the light of the latest available statistics from the Office of National Statistics in order to consider this question. The analysis of the current state of the services sector is based on the release of the most recent data for the Index of Services (IOS) for December 2013 which was released on 26 February 2013 several weeks after the release of corresponding figures for the Index of Production and the Index of Construction. The values of these variables are now available for January 2014 and both show a continuing recovery in output.

    Services constitute the largest sector of the UK economy at around 78% of total output. While agriculture is small, the construction sector is volatile and production is growing slowly, it is the services sector that has been and will continue to be the main engine of economic growth for some time to come. Nor should a service based economy be seen as in any way inferior to one based on manufacturing. Indeed if it is considered that to any buyer the output of a good possesses dimensions of quantity, space or time then the provision of services is as essential as the physical act of production.

    The relatively stronger recovery of services is clearly shown in Chart 1 which graphs the annual average time path of the volume of output for all main sectors of the economy (Index of Production, Index of Construction and Index of Services) between 2006 and 2013. The impact of the severe economic shock sustained by the UK economy as a result of the global financial crisis and subsequent recession is shown across all sectors by rebasing the three indexes to 2006, but only the services index has recovered and surpassed the level of output attained in 2007.

    Chart 1 Annual Volume Output Indexes 2006 to 2013

    Source: ONS, CPS.

    The strength of this sector compared with production output, which has undergoing a steady but feeble recovery since October 2012 and construction which is volatile, but recovering since March 2013, is further illustrated in Chart 2 which tracks the same three indicators of output on seasonally adjusted monthly basis (rebased to November 2011) until January 2014 or December 2013 for the Index of Services.

    The path of services in recent years has been different from overall GDP which at the end of Q4 2013 remained 1.3% below its pre-crisis peak. By August 2013 the Index of Services volume had surpassed its 2008 prior peak and year-on-year monthly changes have shown consistent positive growth averaging 1.5% since June 2010.

    Chart 2 Monthly (Seasonally Adjusted) Volume Output Indexes 2011 to 2013

    Source: ONS, CPS.

    Changes in the balance of the economy as it recovers can be seen by disaggregating the Index of Services into its component parts. The index is composed of four major sectors: the largest sector is Business Services & Finance (comprising nearly 40% of the Index) followed by Government & Other Services (29%), Distribution, Hotels and Restaurants (18%) and Transport, Storage & Communication (14%). Further breakdowns into subsectors are also produced by the ONS, but evidence from the seasonally adjusted data for the constituents of the index already suggest that at the broad sector level the recovery in two sectors Distribution, Hotels & Restaurants and Business Services & Finance has been more robust than the Transport, Storage & Communication and the Government and Other Services sectors. This is evident from Chart 3 which tracks all four sectors on a monthly seasonally adjusted basis from November 2011 to December 2013. This pattern of differential performance is even more marked by looking at Chart 4 which shows monthly year on year volume changes across all four sectors from November 2012 to December 2013.

    The pattern of growth in each sector does show that some rebalancing away from the state has taken place in the recovery with the average real annual growth rate over the fourteen months lowest for Government and Other Services at 0.6% below the rate of Transport, Storage and Communication at 1.1%, Business Services and Finance at 2.1% and Distribution, Hotels and Restaurants at 3.4%. This is a different pattern from the sector impact resulting from the 2008/2009 economic downturn. Then the largest negative effects were felt in the Distribution, Hotels & Restaurants industries and the Transport, Storage & Communication industries, both of which experienced contractions of more than 10% between 2007 and 2009. A smaller contraction was reported in the business services & finance industries. Government & other services, by contrast, remained resilient as a result of the effect of automatic fiscal stabilisers (such as increasing demand for government services related to unemployment, careers, and skills and increased) and additional spending on health.

    Chart 3 Monthly (Seasonally Adjusted) Volume Output Indexes 2011 to 2013

    Source: ONS, CPS.

    Chart 4 Monthly (Seasonally Adjusted) Volume Output Indexes 2011 to 2013

    Source: ONS, CPS.

    This pattern is encouraging for it is upon a private sector recovery that jobs and prosperity depend. For example,  a recent report by PwC argues that the financial services sector of the UK economy could add £62 billion to GDP in the next six years equivalent to an additional 0.2% points every year. Another area where output and employment is expanding is in the Technology Media and Telecoms (TMT) sector. The evidence lies in the increasing demand for prime office space by TMT firms in order to house their operations and growing numbers of employees. Research by real estate agents JLL and DTZ carried out for the City of London found that TMT firms overtook financial services companies as the largest sector, 23% as against 21%, taking up office space in the City in 2013.

    Measuring Services Productivity

    Special care must be taken in interpreting and using this data. Measuring output, innovation and productivity in the services sector is a particularly difficult area conceptually and it may be that the recovery in the services sector is even far more advanced understating economic growth, or even that a measurement bias might work in the other direction. A paper by Burgess (2011) published by the Bank of England has looked at some of the difficulties that arise when trying to measure the output of the banking sector from the perspective of the framework of national accounting. He comments that “formulating a satisfactory definition of ‘output’ in the financial sector is challenging and remains an area of research and debate for both academic researchers and national accounts statisticians.”[1] The ONS began publishing its Index of Services (IOS) between December 2000 and February 2007 as an experimental series. The main reason for the experimental label was that a large scale development programme to improve the short-term measurement of the service sector was launched at the same time as the launch of the IOS. In March 2007, the IOS was reclassified from experimental to national statistic status.

    The problem of defining and measuring output in banking and other financial services are not unique to that industry, but also apply to consulting, advertising and much of the new media. But this issue is particularly serious when it comes to measuring output in the public sector when the services are not sold. The main assumption used by national statisticians had been that ‘inputs=output” so the output of the public sector was simply public expenditure implying that productivity growth is always zero. The United Nations standard of national accounting practice SNA 1993 proposed that countries adopted more direct measures of public sector output which could affect rates of measured GDP growth depending on the productivity of the state in carrying out its functions.

    Progress in this area has been slow despite a European initiative to push through changes in the measurement of public sector output. Early attempts to produce measures of government output in the 1990s in Britain were critically analysed by the Atkinson Review (2005) which made a series of recommendations which lead to the ONS setting the United Kingdom Centre for the Measurement of Government Activity (UKCeMGA) in July 2005 with the remit to implement the Atkinson recommendations and to improve measures of output in the National Accounts based on quality adjustments of the actual impact of public expenditure working with government departments and the devolved administrations. By 2009, the work of the ONS on implementing the Atkinson recommendations had added an estimated 5.1% to the cumulative growth in government output.

    The new methodology finally permits a movement away from the assumption that productivity growth in the public sector is always zero because it allows the measurement of inputs and public sector outputs by deflated volume. Unfortunately, the first long-term results of the work by the ONS unit on productivity in the public sector over the period 1997 to 2010 published in April 2013 was damning and showed that productivity had effectively been stagnant. The initial estimates measured outputs and inputs in eight areas of government activity: Healthcare, Education, Adult social care, Children’s social care, Public order and safety, Police, Defence and Other (general government services, economic affairs, environmental protection and housing and recreation). Social Security Administration was initially excluded from the results until an addendum was published in February 2014.

    Total public service output including quality adjusted variables (such as patients seen etc.) and inputs indices were calculated by the ONS by aggregating output and inputs for all the nine areas of government activity. Total public service productivity is then calculated by dividing this index of output by the index of inputs. The results are shown in Chart 5 which shows that the growth in output was broadly matched by growth in inputs for most of the period 1997-2010. This is extremely disappointing given the vast investment in capital, labour and other inputs over this period.

    Chart 5 Public Service Output, Inputs and Productivity 1997-2010

    Source: ONS

    In effect, the result almost replicates what would have been measured using s the traditional ‘output=inputs’ national accounting convention.  The new calculations are far from perfect. The old methodology was still used for police, defence, ‘other’ services and part of healthcare and children’s social care representing almost 36% of output, but the ONS data indicates that for the remainder of public services, calculated, not assumed productivity was zero. Despite the conceptual measurement issues still to be resolved, which will improve over time, the implication is already clear. Diverting resources from the provision of private services supplied in competitive markets from those provided by a state monopoly or a state guaranteed monopoly, will reduce productivity growth in the entire economy. This will have a negative impact on economic growth. An economic spring has germinated in the services sector. The state should move aside and give the roots of recovery time and fiscal space to grow.

    References.

    Atkinson, A. B., (2005) The Atkinson review: final report. Measurement of government output and productivity for the national accounts. Palgrave Macmillan, Basingstoke, England. ISBN 9781403996466.

    Burgess, S. (2011) Measuring financial sector output and its contribution to GDP, Bank of England, Quarterly Bulletin, Q3. pp234-245.


    [1] Burgess (2011) p.236.

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